When Will 'Junk' Hit the Fan?

Aug.24.10 | About: iShares iBoxx (HYG)

As Joe Public begins to feel uncomfortable with his stock and equity mutual fund positions once again, more and more individual investors are hunkering down and adding fixed income to their portfolios. The capital flows are creating some significant challenges for bond fund managers.

More fixed income capital leads to higher prices … and higher prices lead to lower yields … and lower yields lead to reaching…

The natural progression has been for both professional managers and individual investors to move down the quality chain to find bonds with higher yields and therefore better returns. For the most part, it looks like a careful analysis of the risks has been foregone and instead, a fat coupon payment has taken priority over an issuer’s ultimate ability to repay the principal.

Business Insider notes that corporations are rushing to issue new bonds at attractive rates “as fast as tech companies brought new stock IPOs to market in 1999." But what happens when a slowing economy creates hardships for these corporate issuers – and coupon or principal payments are missed?

All Risk, No Reward

High yield bonds – aka “Junk Bonds” – have seen capital flows increase substantially over the past year as investors first tried to take advantage of very attractive fear-based pricing, and are now viewing the area as one of the few places to generate an attractive yield.

Historically, prices of junk bonds have more closely tracked equity markets than fixed income prices. This is because the default rate is much higher, and when a company defaults on its debt obligations the bond holders usually end up with equity. Whether a default actually occurs or not, prices often closely track equity markets because the same risks that affect equity holders affect investors in junk bonds.

But there comes a point at which further returns cannot justify the risk taken. Junk bonds are, after all, fixed income products. A healthy company will eventually pay its interest payments and principal balance. The most a fixed income investor can hope to receive is the agreed upon schedule of interest and principal payments.

When junk bond prices are high, that simply implies that investors are extremely confident in the ultimate ability of the underlying corporations to make good on their obligations.

But what happens when perceptions change? When companies face cashflow challenges and are unable to make interest payments? When liquidity dries up and firms can’t re-issue bonds to cover maturing obligations?

We’ve seen this type of environment not-so-very-long-ago, and with the global economy on very shaky footing we could see that kind of environment once again.

So at this point it appears that the high prices (and correspondingly low historical yield) of high-yield debt may in fact be much less attractive than equity positions. At least owners of stock have the potential for significant gains if the economy does in fact improve. High yield bond investors have their return capped, with risk much more ambiguous…

HYG – The Trading Opportunity

In years past, it has been more difficult for individual investors to take advantage of mispricings in the high yield market. But with an actively traded junk bond ETF (iShares iBox $ High Yield (NYSEARCA:HYG)), it has become a lot easier to actively trade this market.

Click charts below to enlarge

A quick review of the ETF shows the current rating of the assets held by the ETF, and looking at the top 25 holdings, it is clear that the fund is fairly well diversified across sectors and industries.

Most of the bonds in the portfolio pay hefty coupon payments between 7% and 11%, the actual yield on the ETF for the past year is roughly 8.9%. However, even while the NAV and ETF price per share have spent the last year climbing, the actual payment per share has been steadily dropping all year. This is likely due to the fact that high-yield issuers have been able to issue paper at lower rates, and the ETF has been forced to buy lower yielding securities at higher prices as capital flows must be put to work.

A rush of liquidity has dampened returns for current investors, but looking out a few years there are some very serious issues for high-yield investors. The Financial Times recently warned of a “maturity cliff” – a time period where hundreds of billions in private equity bank loans will mature. As these loans mature, individual companies (most of which will not have high credit ratings) will need to find alternative financing sources and the junk bond market could be flooded with new supply.

Too much supply compounded with economic uncertainty and investor hesitancy could pose a threat to the high yield debt market – and it’s not too early to begin trading in front of this rush of new issuances.

For now, we are waiting for the price action to confirm the next leg lower, and I expect that the broad equity weakness will soon bleed over into junk bond land.

Disclosure: No positions